Purchasing Power Parity & Fisher Effect Flashcards
Absolute purchasing power parity
The equilibrium exchange rate equals ratio of price levels in both nations
Formula
S = P/P*
S= exchange/spot rate
P= domestic price
P*= foreign price
The Law of One Price
A commodity should have the same price in both countries when expressed in the same currency.
What is this law caused by?
Commodity arbitrage
Why do we need PPP (2)
Exchange rate only reflects when goods are traded,
currencies are traded for other purposes e.g to buy capital assets
Different interest rates, speculation or interventions by central banks can influence the FEM.
(basically exchange rate is subject to other factors, so doesnt make it the best way to measure purchasing power)
Purpose of PPP,
and how does it do this? (2)
Find differences in living standards
- by accounting for:
relative cost of living/inflation
Assumption in PPP theory
No transportation or transaction costs , allowing prices of identification goods to be equal when expressed in the same currency, GIVEN a competitive market)
So given this assumption:
Fluctuations in PPP are due to…
Relative inflation differences
Absolute PPP theory be misleading - what does it ignore (2)
Ignores capital account (capital inflows=BoP surplus AS i.e foreign ownership of domestic assets, capital outflows = BoP deficit i.e investing abroad)
Ignores non traded goods - so Will not even give exchange rate that equilibrates trade in goods and services
Relative purchasing power parity
Exchange rate fluctuation should be proportional to the relative change in the price levels of two nations
Formula
S₁ = P₁/P₀ / P₁/P₀ x S₀
S₁ and S₀ is exchange rates in period 1 and base period
Derivation of PPP
Price index of home country (h) and foreign (f) are equal.
Then, the home country experiences an inflation rate of 𝐼ℎ, foreign country experiences If.
What are price expressions now, for home and foreign?
Home price index:
Ph (1 + Ih)
Foreign:
𝑃𝑓(1 + 𝐼𝑓)
If 𝐼ℎ > 𝐼𝑓 (home inflation>foreign) and the exchange rate doesn’t change, where is purchasing power stronger.
- What does this mean for PPP?
Purchasing power is greater on foreign goods (since lower inflation)
- PPP does not exist here. (Since PPP believes E.R adjusts to maintain parity in purchasing power, but hasn’t)
So that scenario looked at inflation, but no exchange rate adjustment to maintain PPP.
If inflation occurs and exchange rate of the
foreign currency changes…
What does the foreign price index from the home perspective become?
𝑃𝑓(1 + 𝐼𝑓)(1 + 𝑒𝑓)
ef is the % change in value of foreign currency
(So same, just added the exchange rate change)
What should ef change to?
Change to a value that maintains parity in the new price indexes of the 2 countries following the inflation
How do we find 𝑒𝑓?
Setting formula for the new price index of the foreign
country equal to home price index.
𝑃𝑓(1 + 𝐼𝑓)(1 + 𝑒𝑓)= 𝑃ℎ(1 + 𝐼ℎ)
Then solve for ef
ef =(1+ Ih / 1+ If) - 1
(same formula as forward premium in IRP but inflation instead of interest)
If domestic inflation (Ih) > If , what happens to ef and intuition?
If domestic inflation (Ih) < If , what happens to ef and intuition?
Ef>0 : foreign currency will appreciate to offset the attractive lower inflation which was causing higher demand for currency
Ef<0 : foreign currency will depreciate to offset higher inflation (since they will supply foreign currency causing depreciation)
ef if the inflation differential is small
ef = Ih - If
(Don’t be confused with forward premium if INTEREST DIFFERENTIAL IS SMALL where p = home interest - foreign interest)
Statistical test for PPP
Regression analysis on historical E.R & inflation differentials
T tests to coefficients: if significantly different from expectation, PPP doesn’t hold.
What do empirical studies say about the PPP theory (2)
Relationship between inflation differentials and exchange rates is not perfect. (Exchange rates to not adjust perfectly to maintain parity of the purchasing powers)
However, the use of inflation differentials to forecast
long-run movements in exchange rates is supported
especially where those movements are large.
Reasons why does PPP not occur consistently (2) (why exchange rates do not perfectly adjust to maintain parity following differences in inflation)
Exchange rates are also affected by other factors than just inflation
(e= f(Int, Inf,Inc,GC,EFER)
Lack of substitutes for some traded goods.
So what does PPP work well, less well, not well for
Well for:
Commonly traded INDIVIDUAL commodities
Over long periods of time (flashcard 22 point 2)
Inflationary periods/monetary disturbances
Less well:
All traded goods together
Shorter periods
Periods of monetary stability
Not well:
All goods (non traded goods esp)
Short run
Periods of major structural change
International Fisher effect (IFE) believes what (2)
Countries with higher inflation have higher interest rates.
Domestic real interest rates tend to equal foreign real interest rates
Implications of IFE (2)
Currency with lower interest rates is expected to appreciate relative to the one with a higher rate.
(Since lower interest=lower inflation, so thus this country will sell more exports thus causing appreciation)
interest rate differential is an unbiased predictor of change in future spot rate
